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Friday, July 22, 2005

Exchange Rates - A Really Simple Example

I am not an exchange rate authority. My goal with this post is to simply show you how exchange rates work and their impact on trade.

We all hear talk about exchange rates and international trade. Most recently, talk has been heating up about China's currency, the Yuan, and the fact that it is pegged to the US Dollar. What that means is that whichever direction the US Dollar moves, the Chinese Yuan follows.

As of yesterday, each US Dollar could buy 8.11 Yuan. Another way to state that is that each Yuan could buy .1233 US Dollars (or each Yuan is worth about 12 cents to us). Here's a simple example of what this means for trade:

Let's say you own a US company and you make rolls of tape that you sell for $1 each here in the US. Now lets say you ship 100,000 rolls of tape over to China to sell there. To get the point across in a simple way, we will assume there are no transaction costs to shipping the tape to China. Once your tape gets to China, they pay you $811,000 Yuan for it. They then charge the Chinese citizen $8.11 Yuan for each roll of tape.

Now let's switch it around and say that the Chinese ship 100,000 rolls of tape to the US that will cost $100,000 Yuan. Since each Yuan is worth 12.33 cents, the 100,000 rolls of tape will cost the US $12,330 (100,000 X .1233 = $12,330), which they then sell to US customers for $.13 each. So, the rolls of tape that were manufactured in the US cost $1.00 each, while the imported rolls of tape from China only cost 13 cents each! That's quite a difference.

Say the Yuan Appreciates 20% Against the Dollar

Suppose the Yuan were to appreciate 20% against the dollar. That would mean that each Yuan would buy .1480 US Dollars (and each US Dollar would buy 6.76 Yuan). Using the same examples as above, the rolls of tape would cost the Chinese 6.76 Yuan instead of $8.11 Yuan (a 16.7% decrease). Meanwhile the rolls of tape would cost the American consumers $.15 each (a 20% increase).

In my opinion the 2 cent increase in price for the American consumer isn't going to hurt us as much as the 16.7% decrease is going to help the Chinese.

Hopefully you have gotten the idea of how exchange rates work. If you have any questions or comments, please leave them.

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